Stewart Cowley: Oh bother!

I have listlessly roamed the Old Mutual Global Investors offices and paced my garden shed, where most of my writing takes place, trying to puzzle it out.

Because the thing that is bothering me is – nothing’s bothering me. We seem to have sleep walked into a set of assertions that we are treating as facts the main one being 'Everything goes on forever' which is clearly nonsense.

My existential crisis stems from the idea that, for all the talk about economic recovery, it’s difficult to see today as anything other than a financial market recovery.

Policymakers have moved to prop up the financial markets NOT the real economy for some time now. If there has been a benefit to the real economy it has been more of a byproduct than a directed aid.

This is very evident in the fact that between the beginning of the current crisis in 2008 and up to this year the FTSE All-Share index returned some 44% in total return terms. The UK government bond market has returned 33% over the same period and yet economic output isn’t back to pre-crisis levels whilst real wages are falling.

The income scramble

This is having very strange effects.

The most obvious ones are in the corporate and government bond markets. There is now a desperate scramble for income in a world where investors only see interest rates staying at emergency levels for years to come.

They are turning to anything with a yield over cash and a chance of getting their money back at maturity. Unflatteringly, some call this a 'dash for trash'.

This couldn’t be truer than in Europe where each day Italian and Spanish government bond yields trundle towards those of German government bonds as though these countries possessed no structural or political issues – the sort of things that makes the internal alarm bells of bond analysts ring off the hook.

In effect what, in the past, would have been a sign of success (yield spread convergence) is, actually, a byproduct of distress and of growing desperation on the part of investors.

The Belgian Dentist

The corporate bond markets are no better.

When I started in the bond markets in 1987 in the Eurobond section of a large American broker (I didn’t last long – it was NOT a nice place) there was the mythical “Belgian Dentist” who was a caricature of a high net worth individual in Europe, with cash to spare, who would buy any old thing that came along and hold it to maturity.

Entire issues would be bought and never traded again. Something similar is happening now but on an industrial scale.

Bond issuers come to market, orders are submitted that are many times larger than the amount available and post-sale the ability to buy and sell at will declines dramatically.

The consequence of this desperate process is that yield spreads are grinding inexorably downwards.

In 2013, mid-range quality European corporate bonds yielded 4% over government bonds. Now you get just 2.5% extra and it is getting less and less as each day goes by. Again, a sign of investor desperation rather than real economy success.

Worse, if you try and raise a cautioning hand up at the hordes rushing towards the corporate bond markets, your corpse will be trampled into the dust as they step through you.

High risk low return, low risk high return

Finally, there are the equity markets; in order to look after the financial system rather than the real economy, successive global Central Bank administrators have turned sensible notions of risk and rewards upside down.

If you map the five major episodes of rising and falling markets since 1995 here in the UK, for instance, what you get are periods of HIGH returns associated with LOW risk and periods of LOW returns are associated with HIGH risk (see below).

That, to any sensible person, is upside down. It lulls investors into taking higher and higher risks because they have the psychological prop of their local Central Banking implicitly and explicitly encouraging them.

It explains why there is a record amount of US equities being bought using margin right now; with just cause, speculators have been conditioned into thinking that the Federal Reserve will help them out if things get sticky.

But it needn’t have gone this far - the net wealth lost by Americans in the period following September 2007 was recouped by September 2012 [1]. Ever since then it’s been free returns in an ever-rising stock market – a further 29%.

Protection

Clearly then, as we come out of the most recent emergency there will be a reckoning for this.

At present the US is the most likely to attempt the process of 'doing the right thing' by the economy, ceasing to pander to the financial markets; get off quantitative easing and prepare for the possibility, at least, that interest rates may, one day, rise.

The UK is somewhat behind, but alongside, the US whilst Europe and Japan are heading into, or remain, in the process of overt market manipulation. The Emerging markets are the creatures of the residual money swirling around.

The disruption to the cosy assumption that the current free ride will go on forever will be very evident when the change comes.

In that case, given that we now appear to be locked into more frequent and more violent financial market cycles, the next phase could see low returns and high volatility for all the major asset classes.

2014 and beyond is about protecting what you have made in the past six years rather than looking for the continuation of easy and extraordinary gains.

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